2023-08-15 13:10:28 ET
Summary
- Dividend investors may find Annaly’s 13%+ dividend yield to be irresistible.
- However, the mREIT sector as a whole is sensitive to the macro-credit cycle and I see tremendous headwinds ahead, even for leading stocks like Annaly.
- The current rate situation, combined with the company’s leverage, creates too much risk.
- The stock’s dividend yield simply does not compensate for these risks.
- Potential investors could get a better entry point during/after the Fed meets at Jackson Hole later this month.
Thesis
Annaly Capital Management ( NLY ) currently yields 13.3% on a FWD basis (and 15.7% on a TTM basis). As such, you have good reasons to be attracted if you are an income-oriented investor. Besides the mouthwatering yield, there are other good reasons to like the stock. It's the leader in the mREIT space, with a size (by market cap) that's more than ~13x of the median mREIT stock. With such a scale, NLY offers efficiency and a sense of being "too big to fail."
The thesis of this article is to point out the risks and to explain why it's a good idea to wait until after the Jackson Hole Economic Policy Symposium. The symposium will be held later this month between Aug. 24-26. As a stock that's sensitive to rates and macroeconomic conditions, I expect the meeting to generate some news that could potentially lead to large volatility in its stock prices, and offer a better entry point. In the remainder of this article, I will detail my thought process and also explain why the volatility could create entry opportunities around or below $18, about 10% lower than its current market price.
The mREIT sector and rates
For readers unfamiliar with mREIT stocks, I have an earlier article detailing the underlying economics . The gist is that the mREIT sector is one of the most sensitive sectors to the macro-debt cycle and a good measure of the cycle is the yield spread. The article was written with AGNC Investment Corp. ( AGNC ) as the main ticker, but the following arguments apply to NLY equally well.
The yield spread between short-term debt instruments and long-term instruments is the most effective indicator of the macro-credit (or debt) cycle. When yield spreads expand or contract, it can signal changes in the underlying economy or financial markets. S tocks like AGNC (or NLY) are typically the ones that are most sensitive about such yield spread changes because they make money on the spread between the long-term and short-term rates. The thicker the spread, the easier and the more money they can make, as you can clearly see from the following chart.
The chart I mentioned in the text quoted above illustrates how AGNC’s dividend payments correlated with the YS in the last debt cycle. Here, I'm using the dividend payments to approximate their true economic earnings. And also at that time, I predicted that the yield spread would further narrow and pressure mREIT’s profitability. Fast forward to now, the YS indeed has narrowed significantly (see the next chart below). It now actually sits at the most inverted level since the 1980s.
With this background, I will now dive into NLY next.
NLY: Not deleveraged enough
As aforementioned, a direct consequence of rising rates is high borrowing costs, which is crucial to mREIT stocks like NLY.
Recall that the Fed lowered rates to almost zero amid the COVID onset back in 2020, essentially providing free leverage to mREIT stocks. And of course, companies like NLY surely sensed such free leverage cannot last forever. So, it was only wise to start deleveraging. As seen in the chart below, NLY reduced its leverage ratio (measured by the total asset/tangible book value ratio) from a level of ~10x in 2020 to only ~6.0x by the end of 2021. Unfortunately, NLY’s leverage has increased substantially since then. To wit, Its Asset/TBV ratio even surpassed in 2022 and almost reached 11x. Currently, its leverage hovers around 9.6x, far above its historical average of 8.1x. Given the degree of YS inversion mentioned above, I see that even the historical average is too high.
13%+ yield is not enough either
Now, back to the mouthwatering 13%-plus yield. Here I will argue why A) the yield is not that high when properly contextualized, and B) the yield does not compensate for the risks the stock entails.
I will make part A of the argument using the chart below. As seen, its current FWD yield of 13.3% is actually on par with its historical average (actually lower by a tiny bit) of 13.4% in the past four years. In contrast, the entire mREIT sector (approximated by REM) is currently yielding about 11% above its four-year average.
For part B of my argument, I see good odds for book value loss with the economic uncertainties ahead. Loss of book value could hurt the stock twice. First, it shrinks the farm from which mREIT stocks generate their yields. And secondly, it triggers stock price declines. The current yield is very likely not enough to battle against these combined effects on the way I see things. The next chart shows these risks in more detail. The top panel shows the stock has been chronically losing its book value (from over $48 a per 10 years ago to the current $17). And the bottom panel shows that its valuations in terms of P/TBV ratio yet show no discount despite the risks mentioned above. Its average P/TBV ratio has been about 1.0x historically. And its current ratio is at ~1.0x.
Jackson Hole, other risks, and final words
As mentioned earlier, I see a good chance that the incoming Jackson Hole meeting may cause volatility in NLY stock price and thus create entry opportunities for potential investors.
For readers unfamiliar with the meeting, the symposium is one of the longest-standing central banking conferences in the world. It's intended to discuss economic issues with crucial concerns, i.e., not only interest rates. However, given the current conditions, I feel rates would be an important topic in the income meeting. In its July meeting, the Fed unanimously voted to increase rates again and Fed Chair Jerome Powell expressed a hawkish tone on fighting inflation. Given his comments, I expect similar comments during the incoming Jackson Hole meeting and see further rate increase to be still in the cards. If history is of any guidance, during last year’s Jackson Hole meeting, Powell expressed the Fed’s determination to keep raising rates until the economy is under control and the stock market suffered sizable corrections after that. I do not see the current setup as too different from a year ago.
Besides the risks mentioned above, another risk that is of particular relevance to NLY and the mREIT sector is a recent downgrade of U.S. debt by Fitch Ratings . The rating agency downgrade was based on several concerns including Congress’ approval of a new fiscal budget and also the ever-increasing government debt. The market (both debt and equity) already reacted negatively to the downgrade. And I see a possibility that the downgrade issue resurfaces during the Jackson Hole meeting and cause more volatility.
All told, I see good odds for NLY’s stock price to suffer downward volatility during/after the meeting. Considering its historical volatility and also valuation metrics, it's likely that the stock price will correct to the ~$18 level or lower, translating into an FWD yield of about 14.6% or a P/TBV ratio of ~0.9x.
For further details see:
Annaly: Wait Until After Jackson Hole